Contractionary Monetary Policy

Contractionary monetary policy is a form of economic policy used to fight inflation which involves decreasing the money supply in order to increase the cost of borrowing which in turn decreases GDP and dampens inflation.

When the economy is under inflationary pressures, the central bank (in US, the Federal Reserve) decreases the money supply by either increase in the discount rate or sale of government bonds or increase in the required reserve ratio or by carrying out all the changes simultaneously.

Contractionary monetary policy has some side effects too. It results in an increase in the unemployment rate and a decrease in the growth rate of the GDP.

Example

Let us use the example we used to explain expansionary monetary policy.

James Traina works as Assistant Economist at World Bank. He is developing policy recommendations for Estovakia and Estrovia. Estovakia has unemployment rate of 7% as compared to natural unemployment rate of 3%, inflation rate of -1% and a growth rate of 0.5% as compared to average of 4%. Estrovia has unemployment rate of 1% as compared to natural unemployment rate of 3%, inflation rate of 9% as compared to average of 4% and a growth rate of 7% as compared to average of 3.5%. For which country James would most likely recommend a contractionary monetary policy?

Contractionary monetary policy is used to reduce inflation. Since Estrovia has inflation rate of 9% as compared with average of 4%, her central bank should implement a contractionary monetary policy to lower the inflation rate, otherwise the economy will heat up and hit a severe recession. However, such a change will increase the unemployment rate and reduce the growth rate. But, such a sacrifice is inevitable for sustainable growth.